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IMPORTANT UPDATES

IMPORTANT UPDATE Number 2 - 25th March, 2014

POST 2013 FEDERAL ELECTION ECONOMIC UPDATE – Portfolio Strategy for 2014 & 2015

Prior to the 2013 Federal Election we forwarded to you Dollar Growth’s Pre 2013 Federal Election Update. At the time we said:

“Currently in many of our Portfolio’s we are carrying higher than usual Cash balances. It is our strong intention not to consider divesting these Cash balances until we have reassessed the incoming government’s policy settings, along with the revised policy settings from Treasury until after the Federal Election”. 


In our opinion the time has now come to reduce the cash balances held in our Portfolio’s. Our intention is to build up the funds invested overseas and in comparison, reduce the funds invested in Australia. For Portfolio’s which are fully invested, we see the International portion increasing at the expense of the funds held in Australia. 

  • 1. Post the 2013 Federal Election….

Since the Federal Election which was held on Saturday 7th September 2013 and the subsequent change of Federal Government, a number of key economic pointers and trends have materialised.

  • - Business confidence has improved to some extent but not as much as may have been first anticipated.

  • - There are not many signs (as yet) that companies are starting to reinvest in capital expenditure. Instead a number of companies are leveraging (i.e. increasing company debt as interest rates are at an historic low for 30 years) and raising capital to mainly maintain or increase dividends to share-holders. The average ASX listed public company dividend rate payout ratio has increased to date by 10.00% for the 2013/ 2014 financial year.

  • - In 2012 about $1.3bn. was raised through equity IPO’s (Initial Public Offerings). In 2013 there were 32 IPO’s and at the end of 2013 only 13 new companies were trading above their initial ASX listing price, 2 didn’t move at all and the rest flopped. 2013 was the best year for floats since the GFC hit us in 2008. But it has slackened off dramatically for 2014 – to date $366m.

  • - The federal Government’s debt is expected to blow out to more than $500bn for 2014. 

  • - Consequently there will be reductions in Govt. spending and overall fiscal tightening.

  • - The budget deficit for 2013-14 is predicted to be at least $45bn. – 50.00% higher than was foreshadowed during the 2013 Federal Election.       

  • - All of our car manufacturers have decided/ been forced to leave Australia.

  • - Qantas has announced the gradual shedding of up to 5,000 jobs.

  • - During the second half of 2012 and calendar 2013, due to the introduction of the Mining Resource Rent Tax, $150 bn. of mining projects were shelved.

  • - The US Federal Reserve’s decision to reduce monetary stimulus from January 2014 (commonly referred to as “tapering”) will reduce the value of the $A vs. the US$ and certain other major world currencies. The $US 10bn. cut in January 2014 to the Fed’s $US 85bn. Monthly bond-buying program is the first of many. Certainly this will make the pricing of our exports more competitive whilst on the other hand it will make imported goods and services more expensive for the Australian consumer. The net effect is expected to be inflationary providing the rate of imports doesn’t fall too much. It is anticipated that further US Govt. bond purchases will lead to further declines in the A$ to around the 75 cents mark.


  • Nevertheless the fall of the $A should prove to be stimulatory for the Australian economy overall and hopefully lead to greater import substitution i.e. the higher costs of imported goods may lead to Australian consumers buying more local goods, providing the quality is at least of the same standard as the alternative, imported goods.

  • - The blow out in costs of the National Broadband network from $37.40 bn. to $66.40 bn. will add further pressure on Australia’s burgeoning budget deficit.

  • - The Productivity Commission has proposed that the eligibility for the Age Pension be increased to age 70. Very few people are aware of the of the changes made by Bill Shorten on April 5, 2013 of extending the deeming provisions to capture income streams (allocated pensions) effective 1 January 2015. Dollar Growth is investigating these legislated changes and will inform clients further by 31st July 2014.

  • - The demands of an ageing population is likely to add an extra 6.00% of gross domestic product to Govt. budgets by 2060 if not dealt with now. In today’s dollars, that amounts to $90 bn.      

  • - Changing the eligibility age of the age pension to 70 years would reap $150bn. in savings over the period from 2025-26 to 2059-60 and increase employment, participation rates among older workers by around 5.00% p.a. 

  • - Without changes to Govt. policy net national income per capita is likely to grow by only 1.10% a year over the next 50 years compared to 2.70% over the past 20 years.

  • - The number of Australians aged 75 years or over will rise by 4 million from 2012 to 2060.

  • - To maintain recent levels of income growth in the absence of growing terms of trade* and labour participation rates would require labour productivity growth to average 3.20% for a decade – something which Australia hasn’t been able to achieve ever, before. 

  • - Australians will need to accept real wage cuts (i.e. the increase in wages growth will not keep pace with the growth in inflation as measured by the CPI). Growing inflation often requires increases in interest rates. The current cash rate is 2.50%, being an all-time low.

*The terms of trade refers to the relative price of exports in terms of imports being the ratio of export prices to import prices. An improvement of a nation's terms of trade benefits that country in the sense that it can buy more imports for any given level of exports. The terms of trade may be influenced by the exchange rate because a rise in the value of a country's currency lowers the domestic prices of its imports but may not directly affect the prices of the commodities it exports.

  • - Dr. Chris Caton, chief economist at BT Financial Group has the view that Australian interest rates will rise by the end of 2014. Australia is grappling with the end of the mining capex boom and he says that “a 2.50% cash rate is unsustainable for the long term.” In terms of the A$ to the US$ he sees fair value as being 80 cents.

 

  • 2. The Way Forward

Currently we see numerous issues ahead that the incoming Federal government will have to deal with, against a back drop of growing, domestic budget deficits and possibly, further deteriorating domestic economic conditions into 2014 and 2015. In contrast, on the International front, that part of the world does appear to be heading in the opposite direction and with greater opportunity.
The Australian economy has to undergo major structural change over the next 5 years and therefore on a relative basis, we see brighter investment opportunities appearing offshore. The implication of structural change is “greater uncertainty” which leads to increases in risk.

  • 3. Portfolio Process

Dollar Growth Financial Planning manages Portfolio’s with a combination of an eye to the future and a continued analysis of the past. Hence the dispersion of Client money over different Asset classes and Investment Sectors. This is termed “diversification” however our philosophy is not to “diversify” just for the sake of it. In moving funds from Australia to Overseas, we assess each Client Portfolio’s on their separate merits weighing up the intention of taking profits on our Australian held, portfolio assets.

  • 4. The Outlook for International assets

Our Global View: We believe that global markets can expect an accommodative US Federal Reserve monetary policy & the Fed will continue to err on the side of easy monetary policy rather than tight. For 2014 we feel that inflation will be stable and low. The softness in commodity prices and continued low wage growth reinforces that this low-inflation trend will continue. We see a modest acceleration in global growth against a backdrop of global disinflationary pressures. Five years after the GFC, the world economy is showing signs of bouncing back this year, pulled along by a recovery in high-income economies.

Developing global growth is becoming brighter but does remain partly sensitive to the US Federal Reserve’s implementation of its “tapering” policy. The Euro area is now out of recession but in some countries per capita incomes are still declining.

A specific theme is Health Care & Pharmaceuticals and we envisage accessing this sector via a specific wholesale fund manager based in Australia. Pharma will continue to become stronger as several drug companies are emerging after their patents have expired. There is also a growing global demand for the realtively cheaper generic brands, a trend that continues in Australia as well. This leads to fiercer competition in the Pharma sector, particularly as product patents expire and the

Generics then come on to the market and endeavour to snatch a greater share of the Pharma market. This leads to brand substitution in favour of the Generic producer and for the long-standing Pharmaceutical companies with the expiring patent, they face a greater challenge to their own profitability and to maintain their prior (most profitable) market share.

A weighting in the Portfolio will also be attributed to Global Infrastructure (ports, toll roads etc) and Utilities (e.g. gas & electricity transmission) and International Property via Australian based Fund managers.

A complimentary theme is investing into recognised Global brands, for example Nestle, Kraft Foods, Colgate Palmolive, Unilever, Phillip’s Industries, Faberge, Google & Microsoft. This is a particular theme that we have managed in our Portfolios’ for some 4 years now and with success.  

South East Asia

Our View: Fundamentals in Asia remain sound over the long term (7 years +); much of the recent bond and currency market volatility represents a liquidity issue, not a solvency issue. South East Asia’s GDP growth rose to an estimated 4.60% in 2013 from 4.20% in 2012 (higher than Australia) and is estimated to be, according to the World Bank 5.70% for 2015 & 6.30% for 2016.
A gradual improvement in Asia will be led mainly by the recovery in global demand and domestic investment. The two largest trade partners of Asia are the US and Europe. However we do recognise political uncertainties can be a feature, for instance Thailand.     

In a nervous start to 2014, Asian equity markets registered their biggest monthly fall in half a year in January. This reduction in equity values was principally due to the fears of slower Chinese growth, the Fed’s tapering, and some emerging Asian economies that rely heavily on short-term foreign currency loans who in turn suffered from contagion fears and accentuated the declines in stock markets.

In Japan, a recovery in investments appears to be underway after new orders for machinery reached a five-year high. The Bank of Japan stated that it was prepared to extend quantitative easing to meet the 2% inflation target.

Overall a recovery in regional investment is anticipated to improve medium-term growth and with consumption growth stabilising from normal harvests and lower international commodity prices.    

Emerging Markets

Our View: We have gained valuable experience in placing client funds into the Emerging Markets sector over the past 17 years. From time to time this Investment sector can exhibit more volatility than a broader based equity investment, but with a time horizon of 8 years+ this is usually overcome. Investing in any asset class or investment sector for the correct time horizon is essential; we agree that “timing” into a particular Sector is important as well and a 60% to 70% timing “get it right” opportunity is perfectly acceptable in terms of portfolio theory.

The following countries are regarded as representing “Emerging markets” – the definition of an Emerging market is “a country that has some characteristics of a developed market but is not a developed market.” The economies of China (excluding Hong Kong & Macau as both are developed) and India are considered to be the largest of the Emerging markets. It can also relate to a country that may be a nation with social or business activity in the process of entering into a longer term phase of rapid growth and industrialisation. Emerging countries include Brazil, Russia, Mexico, Indonesia, Nigeria, Turkey, South Africa, Burma, Cambodia, Laos, Malaysia, Philippines, Singapore, Thailand, Vietnam, Argentina, Chile, Colombia, Egypt, Greece, Hungary, South Korea, Saudi Arabia etc.

In 2013 Emerging market nations that fared the worst were those whose financial houses were in some level of disorder, principally due to the “tapering” by the US Federal Reserve. In the wake of the global financial crisis and the recession that followed in 2007 – 2009, the Federal Reserve carried out large-scale purchases of government bonds and corporate debt securities to lower longer-term interest rates and provide additional stimulus (cash) to the US economy. By doing so it increases the money supply and provides consumers with more cash to spend, that’s the theory of it. On May 22, 2013 the then Chairman of the Federal Reserve Ben Bernanke said that the plan was to scale back the purchases of bonds and corporate debt securities, which is called “tapering.”  This then reduces the money supply and the underlying economic liquidity.

These changes to the US money supply by the Federal Reserve fostered changes in policy expectations around the world and particularly for selected Emerging market countries. However the distribution of these capital movements as a result of the “tapering” were not uniform and did impact on the economic stability of certain Asian economies more than others, in particular those countries where their currency is pegged to the US$. Capital inflows to Emerging economies peaked in January 2013; slowed after that and in the second half of 2013 the US capital flows reduced markedly to emerging Asia and Latin America. These inflows reduced due to the “tapering” i.e. the US government reduced the quantum of US government bonds and treasury securities they were buying back from these countries. It should be noted that the US government could be selective from which country they bought these securities from. 
In the end Malaysia managed to stay on the right side of the ledger, Malaysia at that time was running high fiscal deficit to finance key infrastructure projects. But Indonesia and India got caught and their share markets took a bath as they were punished harshly by investors and were forced to raise interest rates sharply to address this imbalance. India is still suffering from this paradigm. 
During this time the US was experiencing negative interest rates i.e. the actual interest rate is less than the inflation rate. A by-product was that this led to an additional inducement to GDP (gross domestic product) growth in the US.   

However we do see long term value in the Emerging markets as these countries will continue to grow and at some future time some of these countries will out-pace the older, established countries. It also enhances the diversification aspect of a sound client portfolio.

Europe

Our View: Economic activity strengthened in Europe in 2013 supported by strengthening external demand. The return to growth in the Euro Area in the second quarter of 2013 supported real side activity in the region, particularly in the Central and Eastern European countries due to strong trade linkages. European GDP growth is forecast to increase steadily from 1.20% in 2012 to 2.80% in 2014 and a tad more to 2.50% in 2015.

Europe is now out of recession – previously in the beginning of 2013 there had been 6 quarters of negative GDP growth. However we note that EU unemployment is now around the 11% overall mark. We do remain cautious & note that the Eurozone region is on the verge of a sustained recovery. However as we direct new funds into Europe we propose to average the new money in over a 12 to 18 month period via Global fund managers only. The Eurozone is currently running at a substantial current account surplus of approx. 2.00% of GDP. Portugal, Ireland, Greece and Spain are now running current account surpluses. But their unemployment rates are a real issue and is a negative for their domestic consumption.

In our opinion Europe can now be viewed as a longer term growth prospect and we are now comfortable committing funds in gradually over time.  We note that the investment landscape and valuations in the European industry sectors are now within their “normal ranges” and given the higher investment returns over the past 2 years, Europe’s future investment returns will become more dependent upon and influenced more heavily company earnings growth.

At this point of the cycle we are proposing to access Europe via Global Fund Managers which implies that client’s funds will be invested right across the globe rather than placing funds directly into a Fund that only invests in Europe. We also take notice of which companies these international fund managers buy, after all we don’t want to use fund managers that replicate ach others portfolios and that we end up with an undue level of concentration in certain product markets and industries.

Overall we see pockets of European stocks as being cheap historically and some of the larger company stocks as reasonably expensive. Nevertheless discreet investment opportunities are available.

United States

Our View: The boom in US energy production and transportation is far from over and it is anticipated that the US will become the world’s largest petroleum energy producer during 2014. This will improve the US balance of payments; boost employment numbers; reduce CO2 emissions; lift private disposable incomes due to more stable energy prices and therefore potentially making US companies more competitive internationally.

During 2014 and 2015 the US will move further away from unconventional fiscal policy to more conventional fiscal policies. 
  
It is likely that US short and long-term interest rates will “normalise” over the next three years as the US economy recovers due to the US Federal Reserve’s quantitative easing strategy. This will result in the lifting of the Federal funds rate. If Australian interest rates do not move up to the same degree as US rates, the A$ will depreciate further against the US$.

An interesting aspect is that the US monetary policy has via its transmission effects, indirectly forced easier monetary policy on other countries. There are encouraging signs that the US is undergoing a modest to accelerating economic recovery. Since the low point of the December 2009 recession approx. 6.9 million net jobs have been created in the US. The number of people employed is now only 2 million less than the all-time high in 2007. The unemployment rate of 6.70% in December 2013 is much improved when compared to the US unemployment rate of 10.00% in 2009.
                 

  • Portfolio Allocations – For 2014 and going into 2015

These Portfolio Allocations are independent of a Client’s risk profile and should be taken as applying generally and not specifically to your situation.

Investment Sector

Target Weight (%)

Target Range (%)

Australia

 

 

Cash

6

5-25

Fixed Interest (Govt. bonds, corporate debt etc…

7

7-20

Property

8

5-20

Equities (shares)

20

15-40

Alternatives

6

4-10

 

 

 

Investment Sector

Target Weight (%)

Target Range (%)

International

 

 

Cash

3

0-6

Fixed Interest

7

5-16

Property

7

4-15

Infrastructure

8

2-10

Equities (shares)

28***

12-36

TOTAL

100

 

 

Total Assets:

  • Defensive Assets                              23

  • Growth Assets                                   71

  • Alternative Assets                               6

  • Total                                                 100

***Includes a weighting to Health Care & Pharmaceuticals.

I trust that you have found this commentary interesting and that it provides you with a clearer insight and direction for your Portfolio and where we plan to head for this year and into 2015.

Should there be any aspects you wish to discuss please speak to me or Simon. Handan returns from maternity leave on 31st March 2014 which we look forward to.

Yours sincerely,

Philip Enger B.Ec, F. Fin
Authorised Representative of
Financial Planning Services Australia Pty Ltd

 

Disclaimer:  The author of this Economic Update is Dollar Growth Financial Planning Pty. Ltd. a Corporate Authorised Representative (no: 321108) of Hunter Green Pty Ltd. AFSL: 225962 ABN: 12 087 491 629. Any advice contained herein is general advice only and does not take into consideration the reader’s personal circumstances. Any reference to the reader’s actual circumstances is coincidental. To avoid making a decision not appropriate to you, the content should not be relied upon or act as a substitute for receiving financial advice suitable to your circumstances. The material contained herein is provided in good faith and is believed to be reliable and accurate. To the extent it is permissible by law, however, no liability is accepted for errors or omissions or for loss or damage suffered by any person as a result of inaccuracies in the publication.

 

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